Oscillating Indicators in Stock Market

Prices keep fluctuating up and down in the stock market, and to make sense of these fluctuations, traders and investors use technical analysis tools such as oscillating indicators. These oscillating indicators help identify whether a stock is overbought (potentially overpriced) or oversold (potentially underpriced), giving clues for best entries and exit points.

One common type of oscillating indicator is the momentum indicator. The objective of this indicator is to ascertain the weight of evidence in determining whether a trend has been reversed or retains enough strength to continue in its current direction, thereby aiding in making better trading decisions.

In this blog, we will explain oscillating indicators and explore different types of oscillators in technical analysis, such as stochastic and RSI indicators.

What is an Oscillator in Trading?

In trading, an oscillator indicator is one that fluctuates between two values or two price levels. It is a technical analysis tool that helps recognise potential overbought or oversold conditions in the price of an asset, such as stock, commodities, or currency. It is called an oscillator because it moves or oscillates between two extreme levels, typically represented on a scale of 0 to 100 or between two fixed values.

Types of Trading Oscillating Indicators

Some of the common types of oscillating indicators or oscillators that many experienced traders use are mentioned below:

1. Momentum Oscillators

Momentum oscillators are trading oscillators that help measure the speed or rate of change in price movements.

Examples of Momentum Oscillators 

• Relative Strength Index (RSI): The RSI Indicator helps measure the magnitude of recent price changes to examine overbought or oversold conditions.
• Rate of Change (ROC): As the name suggests, ROC helps measure the percentage change in price between the current period and the price a certain number of periods ago.
• Stochastic Oscillator: This momentum oscillator compares the closing price to the price range over a specific period to identify overbought or oversold conditions.

2. Trend Following Oscillators

Trend following oscillating indicators play a crucial role in identifying the strength and direction of a trend in which the underlying stock or index is going.

Examples of Trend Following Oscillators

• Moving Average Convergence Divergence (MACD): MACD shows the relationship between two moving averages (the default setting uses 12-period and 26-period EMA) and includes a signal line for trade signals.
• Average Directional Index (ADX): ADX helps measure the strength of a trend but not its direction. ADX values above the level of 25 indicate a strong trend.

3. Volume Based Oscillators

As its name suggests, a volume-based oscillator is based on volume. It incorporates trading volume to confirm price movements or helps identify potential reversals.

Examples of Volume Based Oscillators 

• On-Balance Volume (OBV): OBV adds or subtracts volume based on price movements to predict price changes.
• Chaikin Oscillator: The Chaikin Oscillator plays an essential role in measuring the accumulation or distribution of a stock by combining price and volume. Long term EMA is subtracted from short term EMA in calculating Chaikin oscillator.

4. Volatility Oscillators

The primary function of volatility based oscillating indicators is to gauge the rate of price fluctuations, regardless of the direction in which the underlying stock or security is going.

Examples of Volatility Oscillators

• Bollinger Bands: The brainchild of John Bollinger, Bollinger Bands helps assess volatility by plotting standard deviation bands on the upper and lower sides. The upper and lower bands take into consideration a moving average.
• Average True Range (ATR): ATR assists traders in measuring volatility of a stock or asset by calculating the average range between high and low prices over a period.

Key Features of Trading Oscillators

The key features of trading oscillators that make them useful for traders are mentioned below for your convenience.

• Help Spot Divergence: A divergence occurs when the price and the oscillator are out of sync. In short, the price moves in one direction while the oscillator moves in the opposite direction.
  There are multiple types of divergence that can be spotted. However, the most commonly used are bullish and bearish divergence.
• Identifying Overbought and Oversold Levels: Trading oscillators help traders identify overbought and oversold levels in assets. Overbought levels indicate that the stock is potentially overextended on the upside, and oversold levels indicate that the stock is potentially overdone on the downside. In RSI, levels of 70 and 30 are generally considered as overbought and oversold levels, respectively.
• Insights into Volatility: Some oscillators help measure stock volatility. Periods of high volatility often lead to a broader oscillator range, while low volatility results in narrower ranges. Bollinger Bands and ATR are commonly used to measure market volatility.

How Oscillating Indicators Works in Trading?

Oscillators work in trading by measuring how fast prices are moving and whether they are going up or down. They create numbers that move above and below a middle line, also called the center line. These numbers assist traders in understanding whether stock prices are too high (overbought) or too low (oversold) and predict if the trend might reverse.

Limitations and Considerations

Even though oscillators provide useful signals, traders should be mindful that oscillators are based on mathematical formulations and mostly, these oscillators have been the work of the past. Hence, they have certain limitations in this evolving market, so avoid relying solely on them. It’s important to consider other factors as well so that your trading journey is not hampered. Let’s explore the limitations of oscillators:

False Signals in Trending Markets

As we mentioned in the features of trading oscillators, oscillators help identify overbought and oversold stocks, but they can be misleading sometimes. Because, in a strong uptrending market, a stock may remain in an overbought zone for a long time. Similarly, in a strong downtrend, a stock may remain in an oversold region for long, leading to false signals while buying or selling the stock solely based on overbought and oversold readings.

Volatility Distortion

Volatility is cyclical, and a period of heightened volatility may follow a low period of volatility. Periods of heightened volatility can impact the signals an oscillator provides, which it would not have provided during a period of low volatility. Hence, volatility distortion can impact the accuracy of oscillator trading signals.

Lack of Fundamental Consideration

Mathematical formulas drive the output of oscillator indicators, and these formulas do not consider fundamental analysis, tailwinds, or headwinds in a particular sector or industry that an investor or trader is analysing. Hence, traders and investors can use oscillator indicators with fundamental and industry-specific analysis for a better and more reliable perspective.

Divergence and Convergence in Oscillator Analysis

Divergence and convergence are key features in oscillator analysis. They assist traders with additional information for trend reading at an extreme end or the continuation of the ongoing trend.

Bearish Divergence

A divergence is spotted when the direction of the price and the oscillator do not match. A bearish divergence occurs when the price makes a higher high, but the oscillator does not behave the same way when it makes a lower high. A bearish divergence is a sign of a possible trend reversal on the downside. Divergence is widely used in the RSI indicator.

Bullish Divergence

Bullish Divergence is the opposite of bearish divergence. In a bullish divergence, the price is lower, while the oscillator makes a higher low. Bullish divergence helps in identifying a reversal from a downtrend to an uptrend.

Conclusion

Trading with oscillators has become more relevant in modern times. Technology has made it possible to plot different types of oscillators with just a single click. Oscillators help analyse market conditions and provide actionable trading signals. However, oscillators have limitations, making it crucial to know when to use and avoid them.